Risk shifting or just risk adjusted returns (2016)

Intuitively, option-like compensation contracts induce risk-shifting behavior, confirmed by numerous empirical studies. However, recent theoretical work has shown that without a definite expiration date of the option, risk shifting should not happen. With a sample of Commodity Trading Advisors (CTAs), we show that increases in risk (interpreted as risk shifting) correspond to even greater increases in return, as shown by increasing Sharpe ratios. Second, controlling for expected returns eliminates measured risk shifting. Finally, measured risk shifting behavior, strong between 1994 and 2003, is substantially lower or missing from 2004 to 2014. Thus, we conclude that CTAs (and likely other hedge funds) do not risk shift, confirming recent theoretical results.